Comments Off on It’s time to question the macroeconomic orthodoxy on interest rates and inflation

Mark Carney, governor of the Bank of England, is getting his retaliation in early.

Faced yet again with the Bank failing to deliver its designated target of a two per cent inflation rate, in a speech last week he suggested that his remit was broader.

“We face a tradeoff between having inflation above target and the need to support, or the desirability of supporting, jobs and activity”, the governor stated.

In other words, he claimed that the Monetary Policy Committee (MPC) of the Bank should be concerned not just with inflation, but with what economists describe as the “real” economy, output and jobs.

The Federal Reserve in the US is explicitly mandated to take account both inflation and the real economy when it sets interest rates. This is definitely not the case with the Bank of England. When Gordon Brown made it independent in 1997, its remit was unequivocal. It was to ensure that inflation was two per cent a year.

This time round, inflation is above the Bank’s target. The current level of some three per cent may even rise in the short term because the weakness of sterling is pushing up the cost of imports.

But in recent years, inflation has been below the two per cent desired rate, even falling to zero in 2015.

All this time, Bank rate has been essentially flat. The MPC cut it to just 0.5 per cent in March 2009, where it remained until the reduction to 0.25 per cent in August 2016.

To put this into perspective, when the rate fell to 1.5 per cent in January 2009, this was the first time it had been below two per cent since the Bank was created in 1694, well over 300 years ago.

So here is a puzzle for mainstream macroeconomists, whether in central banks or universities. Central banks are meant in theory to be able to control inflation by setting short term interest rates. Inflation has been low since 2009. But at the same time, the Bank rate has been at all-time record lows.

Perhaps more pertinently, inflation has fluctuated from year to year, even though interest rates have to all intents and purposes not changed. It was 4.5 per cent in 2011, and 0.7 per cent in 2016.

In short, inflation seems to lead a life of its own, independently of what the experts on the MPC either say or do.

Inflation really is a naughty boy all round. A central concept in orthodox economic thinking, encapsulated in the quote from Carney above, is that there is a tradeoff between inflation and jobs and output. The faster the economy grows and unemployment falls, the higher inflation will be.

But starting in the early 1990s, for around 15 years across the entire Western world, both inflation and unemployment experienced prolonged falls.

The idea that a central bank can control inflation by adjusting interest rates is shown by the evidence to be absurd.

It is yet another example of the limits to knowledge in orthodox macroeconomics.

Comparisons of the size of economies, particularly ones at very different levels of income per head, are fraught with difficulties. Taking a deep breath, annual output in China is currently around $10 trillion a year, compared to $17 trillion in America.

Over the past 30 years, the US has grown at an annual average rate, after allowing for inflation, of 2.4 per cent, and China by 9.3 per cent. If we project these rates forward, the Chinese economy will be as big as the American by 2024. By 2037, it will be more than twice the size.

We can allow for some slowdown in China’s growth, to, say, 7 per cent a year, and a bit faster expansion in the US, to take account of the fact that the average over recent decades is influenced by the impact of the financial crisis. Even so, we soon reach a situation where the two are of comparable size.

But a paper in the latest issue of the world-class Journal of Economic Perspectives argues persuasively that the sustainable Chinese growth rate in the medium and longer term is much lower, in the range of 3 to 4 per cent a year.

Hongbin Li and colleagues, based both in Stanford and top universities in China, note that Chinese growth since the start of the economic reforms in 1978 has been the fastest that any large country has sustained for such a long period of time. But much of this is due to the rapid transition from a centrally planned to a market oriented economy. Forty years ago, virtually no-one operated in the private sector. Now, well over 80 per cent of workers do so. This shift obviously cannot be repeated.

Closely intermingled with this has been the massive move of population from the countryside to the cities – or more precisely, from low productivity agriculture to higher productivity urban economic activities. But the annual growth rate of rural-to-urban migration has fallen from over 11 per cent in the 15 years before 2000 to only 3 per cent since. And the authors argue that the growth of migration almost certainly will decline further given that “rural-based surveys are finding that less than 10 per cent of young able-bodied rural individuals are now living (and working on farms) in rural areas”.

The governor of the Bank of England, Mark Carney, was on good form last week when he appeared at the Treasury Committee of the House of Commons.

Asked what “forward guidance” meant, he answered smoothly: “The thing about forward guidance is that it is guidance that is forward. Which is not to say it is meant to be in any way accurate. Indeed, it would be surprising if it were. The most important thing about forward guidance is that the underlying economic determinants should be correct, not that it should be helpful.” Cue collective bafflement of the assembled MPs!

But the statement actually tells us a great deal about how mainstream macroeconomists believe the economy operates.

The first attempt was certainly not in any way accurate. The governor stated that the MPC would not consider raising interest rates until unemployment fell to 7 per cent, which he predicted would take about three years. It took less than six months. By January 2014, the rate of unemployment had fallen to 6.9 per cent.

This just seems to have been a piece of poor analysis by the Bank. But it does not detract from the more fundamental reason economists think that forward guidance will not usually turn out to be accurate.

The forward guidance is deliberately based on the assumption that behaviour will not change. Yet the mere fact that the central bank makes a pronouncement about the future might induce people to alter their behaviour. And if behaviour changes, the forward guidance might very well prove to be inaccurate.

It is actually a sensible addition to the Bank’s armoury of policy levers. Properly managed, it might enable the Bank to nudge behaviour in directions which it believes will give a better outcome than would otherwise be the case.

The final part of Carney’s statement appears the most gnomic: “The most important thing about forward guidance is that the underlying economic determinants should be correct, not that it should be helpful”.

The governor meant that forward guidance should be given on the basis of a model of the economy which is correct.

In each of the various different macroeconomic models which exist, the assumption is made that consumers and firms form expectations about the future as if their particular model, and no-one else’s, were correct. Yet despite many years of intensive research, macroeconomists still do not agree on what constitutes the model of how the economy works.

There is a challenging academic literature on the theory of how people go about learning the correct model of the economy. But in practice economists are unable to apply it to themselves. We might reasonably conclude that it is the theory which is wrong. Forward guidance is just the latest technocratic delusion foisted on us by mainstream macroeconomics.

Tempers are fraying at the highest levels of economic policy-making in the UK.

Theresa May, at the Conservative Party conference, emphasised the “bad side effects” for savers of the Bank of England’s policy of near-zero interest rates, a position reinforced by former Tory leader William Hague in the Telegraph this week. A few days ago, Mark Carney, the governor of the Bank, hit back by saying he would not take instructions from politicians.

He went on to discuss inflation. The fall in sterling puts up the price of imports, and some economists predict that inflation will hit 3 per cent next year, up from its current (still low) level of 1 per cent. The Bank’s Monetary Policy Committee (MPC) has an official remit of maintaining inflation at 2 per cent. Carney stated that he would allow inflation to run “a bit” above this to protect growth and employment.

Just how much power does the MPC have to control inflation in such a precise way? At first glance, the work of the MPC has been brilliant. Some years the inflation rate has been higher than the 2 per cent target, like in 2011 when it was above 4 per cent, and some years lower, as last year when it was zero. But over the past 15 years, inflation in the UK has averaged 2 per cent a year, almost exactly in line with the target.

But the average inflation rate has been very close to 2 per cent averaged across the 28 member states of the European Union. And the United States also registered the same average of around 2 per cent over the past 15 years.

The fact that inflation has averaged more or less the same rate across the major economies for well over a decade – only in Japan has it been substantially different – strongly suggests that there is a common factor at work. It could be the collective skills of central bankers, or it could be the effect of plain, old fashioned competition.

Competition in markets for goods and services means that it is hard to make price rises stick, and competition for labour means it is difficult to secure substantial wage increases. Competition in the global economy is the main reason inflation has both been low and very similar across the developed world.

The MPC controls the short-term rate of interest, and the theory is that a rate increase, say, reduces demand in the economy as a whole. This in turn has a stable and predictable impact on inflation, with lower demand leading to lower inflation. The trouble is that the facts do not fit the theory. Inflation dropped to zero after peaking in 2011, but unemployment has effectively halved and the economy has grown at a decent rate.

We do owe central bankers in the UK and the US a massive vote of thanks for preventing the crisis of the late 2000s from becoming a repeat of the Great Depression of the 1930s. But even they do not have magic powers. Inflation is low because of competition, not central bankers.

One of the surprises of last week was the Office for National Statistics (ONS) estimate of economic growth in the second quarter of 2016, the period from April to the end of June. In the run up to Brexit, the economy expanded by 0.6 per cent on the first quarter of the year. This was an acceleration, with the first quarter of 2016 only being up 0.4 per cent on the previous one.

The situation in the third quarter is currently confused. The GFK consumer confidence survey for July showed the biggest monthly drop since 1990. But the weakness of the pound means that exports are due for a boost. Certainly, judging from the sheer numbers of foreign tourists crowding London in the last few weeks, we are raking in the euros and the dollars.

But the ONS view on what happened in the second quarter of 2016 is by no means the last word. Quite rightly, our national statisticians are keen to provide information on what has been happening in the economy as fast as they can. So they publish what is known as the “first estimate” of GDP growth for a quarter just a few weeks later. It is this estimate which grabbed the headlines.

Most economic data published by the ONS are estimates, produced with information gathered from a wide variety of sources. But as time goes by, more of it comes in for any particular quarter. Self-employment income, for example, is quite important these days. But an accurate picture is not available until after the end of the tax year, when all the returns are submitted. So the initial estimate might very well change over time.

Looking back over the past 20 years, the average of all the first estimates of growth made over this period is a bit lower than the average of the latest estimates. So, on balance, first estimates get revised upwards, showing that the economy has been more buoyant. But statistically speaking, we cannot say with real confidence that they are significantly different.

Certainly, the averages can conceal some large inaccuracies in the first estimate data. The ONS now thinks we entered the recession of the late 2000s in the second quarter of 2008, with the economy shrinking by 0.7 per cent compared to the first quarter. But the first estimate which was made showed modest growth of 0.2 per cent. The first estimates did indicate a recession in the second half of 2008, but underestimated how much the economy was contracting. In contrast, during 2009, the first estimates failed to register the speed of the economic recovery. In the winter of 2011-12, the first estimates notoriously suggested we had entered a new recession, which is not borne out by the latest data.

It is a hard life being a policy-maker. One of the problems is reading the runes about where the economy is now and where it has been in the recent past. The first estimates of GDP are better than nothing, but can on occasion be quite wrong.

The Brexit vote creates many uncertainties, exciting or frightening depending on your predilection. One thing which is certain is that the Leave victory was delivered by the less-skilled sections of the electorate.

It seems part of a more general stirring up of what we might think of as the dispossessed, those who feel left behind by globalisation. In France the Front National, in the Netherlands Geert Wilders’s Party for Freedom, in Germany Alternative fur Deutschland – throughout Europe, in fact, these discontents receive an increasingly sympathetic hearing.

Equity markets have been very volatile and nervous in the face of the uncertainties which Brexit creates. But there may be a good reason for this from a longer-term perspective.

Compared to 30 years ago, stock prices both in Europe and the US are at much higher levels. A key reason underpinning this is the shift from wages to profits as a proportion of national income which has taken place. The share of wages in national income has fallen, and that of profits has risen. Profits have grown faster than the economy as a whole, and so the potential future dividend stream from shares has gone up. As a result, shares have become more valuable.

Measuring the share of wages in national income is not as straightforward as it might seem. Should it, for example, include self-employed income or the remuneration of chief executives? In February 2015, the OECD, along with the International Labour Organisation, published a detailed study of trends in the G20 economies since the early 1990s. No matter which measure was used, the data show that the wage share declined significantly in almost every member state of the G20, and nowhere was there a significant trend increase.

The changes themselves may appear small. On one measure, for example, the wage share fell from an average of 69 per cent of national income in 1990 to 65 per cent now. But in terms of, say, the UK economy, four percentage points represents nearly £80bn.

More recently, there has been a levelling off in the downward trend. The distribution of income between wages and profits has been stabilising. Does Brexit signify a tipping point, when the trends of the last few decades might start to be reversed?

The economic orthodoxy, not just in theory but in practice, has been one of open borders for both labour and capital. Both must be allowed to flow freely. But there is an increasing groundswell of public opinion against this. Donald Trump, for example, supports a 20 per cent tax on all imported goods to protect American jobs. Bernie Sanders has opposed every free trade deal which the United States has negotiated, and vowed to “take on corporations which take their jobs to China”.

It is much easier to protect wages in a world of tariff barriers and restrictions on capital movements. Boris Johnson sees Britain as a global entrepreneur, but most Brexit supporters do not. Brexit would not be the cause of a long-term downward revision to share prices, but more a symbol of why it’s happening.